The Treasury’s economic modelling of Brexit has been proven wrong – yet it has failed to abandon its unjustified pessimism

The Treasury’s economic modelling of Brexit has been proven wrong – yet it has failed to abandon its unjustified pessimism

During the referendum campaign the Treasury produced two forecasts for the UK economy  under a ‘full’ Brexit outside the Single Market with WTO rules (the WTO Option): one on the long term outlook a decade hence and one on the short term outlook up to five years ahead. Both were pessimistic: the first argued that output would be lower, compared with the status quo, by around 7%, the second that there would be a short term recession, cumulating into this long-term decline.

This recession came from two causes: first the bad, long-term prospect fed into short-term confidence through people anticipating the effects of Brexit policy as analysed by the Treasury and other experts (‘rational expectations’) and second, policy uncertainty would create additional cuts in spending. Similar forecasts were made by the IMF, the OECD, the CBI, and the NIESR among others.

Economists for Brexit (EFB) published several comprehensive critiques of the Treasury’s two reports and also of reports by other groups, all of which can be found on our webpage. We also produced our own, positive, forecasts of the WTO Option outcome, short and long term, which can also be found there.

So where are we now, nearly five months after the referendum?

Let me consider first the long-term report.

Our analysis found a major (more than 4%) long-term gain to GDP and consumer welfare from the WTO Option. This is because consumers lose substantially to producers due to the EU Customs Union and its accompanying Single Market. They do so because

  1. EU protection of food and manufacturing raises their prices (around 20%) and lowers productivity;
  2. Regulation raises costs and lowers living standards; and
  3. Free unskilled migration creates a net cost welfare burden that consumers must shoulder through higher taxes, with poorer consumers having to shoulder a disproportionate share of these.

In addition, by removing the UK totally from the EU, we eliminate other potential costs, on growth, on bailout transfers, and on the threat of sometime joining the euro. In sum there are massive gains to be made by removing the UK totally from the EU: this, in effect, amounts to a second supply-side revolution.

However, as we have seen, the Treasury and other modellers came up with negative effects of leaving the EU and this was heavily publicised by the Remain side as a ‘consensus’, even an ‘economic fact’. How did this arise?

First, the Treasury, the IMF and LSE, used a ‘gravity’ model which created a strong bias against leaving the EU owing to the way it was estimated and used: essentially a gravity model assumes that current trading patterns are hard to alter because ‘gravity’ (interpreted as geographic closeness) determines trade patterns. For Britain this is a model of doubtful relevance as we have strong trading links all over the world, given our long international history, and transport costs have been all but eliminated by containerisation.

Second, even though other groups such as Oxford Economics and PWC, for the CBI, used a model closer to ours, they still found a negative effect: the reason for this, it emerged from an NIESR conference in late May, was that they assumed the UK would continue to maintain high EU-style protection after Brexit – rather than unilateral free trade. This factor also caused the gravity modellers to find an even more negative effect, so it was the most general factor for a negative result.

When challenged on why they made this Brexit protectionism assumption, these modellers said that ‘unilateral free trade is politically impossible’. In the context of a referendum where voters were being presented with analysis to make up their minds, this was a strange decision: economics should present all options and allow voters to decide. More to the point, now that the government is pursuing Brexit, it is vital that it chooses the optimal policies and make sure they are politically possible by suitable accompanying measures!

Now that Brexit has been voted for, Remainers are still arguing in favour of producer interests, for an EEA-style agreement that will frustrate voters’ best interests by maintaining the status quo! It seems that the Treasury has not abandoned this position either.

Now let me consider the short term Treasury report. Here the quite arbitrary assumption was made that there would be huge policy uncertainty, comparable to that after the financial crisis of 2008-9. Adding this to the Treasury’s short-term model – on top of the long term decline predicted by the Treasury’s long-term model – produced the predicted recession. This was due to start happening from the second quarter when uncertainty from the referendum was the greatest with Brexit policies as yet undecided.

However there was a remarkable rise in second quarter growth, from 0.4% in Q1 to 0.7% in Q2. This clearly implied that business decisions could not have been much affected downwards by worse expectations and uncertainty due to Brexit.

Furthermore, after the vote came out for Brexit, the economy continued to do well, with Q3 growth put at 0.5%. There is likelihood of some upward revision into line with the most recent Purchasing Managers’ Indices that indicate continuing growth in all sectors against the early estimated falls in manufacturing and construction. EFB’s pre-referendum forecast for 2016 (of 2.3%) was in line with these outturns and consensus forecasts are now converging on this.

In conclusion, what we have seen is a total contradiction of the Treasury’s forecasts within a few months of the Brexit vote. The short term has remained buoyant. In so doing it has not merely shown how wrong the ‘policy uncertainty’ effects were but has also already contradicted the long-term forecasts which should, according to the Treasury, have damaged short-term spending plans.

Yet far from abandoning its pessimistic projections based on damaging assumptions inconsistent with the government’s own Brexit policies, the Treasury has, it seems from recent statements by the Chancellor, simply pushed them into its forecasts for next year while retaining its long-term view of GDP decline – a Project Fear Mark 2. This Treasury behaviour is damaging to this government’s efforts to pursue beneficial Brexit policies and should be stopped. Indeed it amounts almost to treasonable sabotage.